On Friday, March 27, 2020 the United States government implemented legislation that provided comprehensive relief to America in what is otherwise known as the CARES Act. The CARES Act included loans and payroll credits to businesses, cash to individuals, and funding to support additional resources needed during this time. Retirement plans of individuals and businesses also experienced relief through this Act. The Act provided a four-pronged approach to reduce the burden of retirement plan rules. The tools provided include:
- Relaxed funding rules for employer defined benefit plans,
- Waiver of penalties for early distributions,
- Lenient rules for loans, and
- Waivers of minimum distributions for those who are retired or have an inherited retirement account.
Funding Rules for Employer Defined Benefit Plans
While not as popular as they had been in years past, defined benefit (DB) plans can accomplish certain strategic goals for a business owner. A DB plan is a retirement plan that considers what the total retirement benefit should be for any individual within the plan. Annually, actuaries calculate the minimum amount needed in cash to fund the plan so that all participants are projected to hit their target retirement benefit when they retire.
Let’s contrast this with a defined contribution (DC) plan. In a DC plan, the participant is limited to the annual maximum contribution. From the annual maximum contribution as provided by law and making market and portfolio mix assumptions, the plan participant can project how much might be available at retirement.
Defined benefit plans were subject to abuse in the past. DB plans were established and not funded and many retirees were left without retirement funds because the plans had not been funded and the company had gone bankrupt or closed down. Therefore, rules were set up to require plan sponsors to make the appropriate funding annually.
In a year where the plan assets perform well or better than expectations, the actuary might recommend a lesser contribution than what was expected. In a year where the plan assets perform poorly, more cash might be required to keep the plan in compliance. During a period of time where the market is decreasing and assuming that the defined benefit plan is invested in the market, there could be a point when the actuary might recommend that more be placed into the plan than what was anticipated by the business owner.
It’s not exceptionally helpful to have a larger request for cash during a time when the general business climate is struggling as well. In response to this concern, provisions found within the CARES Act extend the due date for depositing contributions that would otherwise be due in calendar year 2020 to January 1, 2021. Other provisions within the Act allow companies to use their plan’s funded percentage for the immediately preceding plan year to determine the plan’s funding for the 2020 plan year. This should allow companies to look at plan assets before the downturn in the market and provide a bit of funding relief to what we hope will become a less volatile market and business climate in the future.
Early Distribution Rules Temporarily Modified
Tax provisions have historically encouraged us to save for retirement. Saving for retirement allows us to put our savings in an account that generally affords us tax deferral (taxes saved now, and taxes paid later). Usually taxpayer favorable situations come with strings attached, and retirement plan contributions are no exception. If a taxpayer is under 59½ years old and wants to take funds out of a retirement plan, the taxpayer will pay income tax on the deferred amount plus earnings and a 10% early distribution penalty.
Among the many measures implemented to support the American economy, the CARES Act gives taxpayers of any age the ability to take a distribution of $100,000 from a retirement account, penalty free. This includes IRAs or qualified plans. The normal requirement to withhold 20% in federal taxes is also waived.
The taxpayer has up to three years to recontribute the distribution. It’s treated as a rollover into the plan. And, the funds are not required to be recontributed back into the same retirement plan. If the taxpayer cannot recontribute the distribution, then the taxpayer will report this distribution in income over the next three years. The taxpayer also has the option to pay the tax in one year instead.
In order to qualify for this special tax treatment, the distribution must be a “coronavirus” distribution. A coronavirus distribution is defined as any distribution from an eligible retirement plan after January 1, 2020 and before December 31, 2020, to an individual whose self, spouse, or dependent was diagnosed with the virus by a test approved by the CDC. Additionally, a taxpayer who experiences negative financial consequences as a result of COVID-19 situations also qualifies. In summary, this provides quite a broad interpretation.
While these rules are helpful, especially in a time where cash might be desperately needed, it’s important to consider the potential negative long-term impacts this can have to an individual’s retirement funds, which could require the individual to work longer than anticipated or to contribute more on an annual basis than what was originally planned.
Expanded 401(k) Loans
For qualified plans such as 401(k) plans, the bill expands the ability for employees to take loans from their qualified plan. Prior to this law, a loan in the amount of the lesser of $50,000 or 50% of the plan balance was permitted if the plan was written to allow it. Under the new law, the lesser of $100,000 or 100% of the plan balance can now be borrowed. Additionally, those who already have a qualified plan loan can delay repayments for up to one year. During the deferral period interest continues to accrue but the statutory 5-year repayment period is delayed.
Plans are permitted to dictate whether these loans are allowed. Consideration should be given as to the financial impact of repaying a loan of this magnitude and to the recordkeeping required to keep track of loans. Once the decision is made by the employer to adopt the loans within the plan, the new rules can take effect immediately. Business owners should then work with their advisors to amend the plan documents which are required to be amended on or before the last day of the first plan year beginning on or after January 1, 2022, or later if prescribed by the Secretary of the Treasury.
Temporary Waiver of Required Minimum Distributions
Certain taxpayers are required to take a minimum amount out of a defined contribution plan or most individual retirement accounts (IRAs) once they reach a certain age or upon inheritance (discussed later). These minimum amounts are called required minimum distributions (RMDs). In recent past, the age for RMDs has been 70½. Under the SECURE Act (passed on December 20, 2019), if the taxpayer’s 70th birthday is July 1, 2019 or later, RMDs are not required until the taxpayer reaches age 72. Roth IRAs do not require minimum distributions until the death of the owner.
Inherited IRA and qualified plan beneficiaries are also required to take distributions. The newly passed SECURE Act changed the rules slightly and are beyond the scope of this article. For more information regarding inherited IRAs and qualified plan beneficiary RMDs, Publication 590-B is helpful and can be accessed here: https://www.irs.gov/publications/p590b.
The penalty for not taking an RMD can be 50% of the amount that should have been distributed.
RMDs are calculated based on the values as of December 31st of the prior year. When markets are experiencing volatility or even worse, losing value, taking money out of the investment account can have exponential long-term negative impact for at least two reasons. The RMD was calculated on a larger balance and the corresponding distribution will erode the principal faster over the owner’s lifetime and because the assets need to stay invested to regain value over the long term. This is certainly understood by our governing bodies and because of that, the CARES Act provided relief by waiving required minimum distributions for 2020. This applies to both 2019 RMDs that are required by April 1, 2020 and RMDs that would have otherwise been required for 2020.
We believe there will be more guidance from the IRS regarding these rules and we will continue to keep you informed. More information about RMDs can be found on this link to the IRS website: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds.
In summary, we recommend you consider the following:
- Don’t panic,
- Reach out to your plan administrator regarding your DB plan to understand your options,
- Avoid taking a loan or distribution; consider it a last resort,
- As an employer, consider 401(k) loans and its impact on your employees, and
- Consider converting your IRAs to a Roth IRA. For more information visit this article: The Case of Roth Conversion
As your trusted advisors, we are committed to keeping you well-informed with any new legislation passed by Congress as well as any new pronouncements by the Department of Treasury that may affect you. Please do not hesitate to reach out to KHA with any additional questions you may have.
These sources are simply included for informational purposes. KHA Accountants, PLLC, its partners and others do not provide any assurance as to the accuracy of these items or the information included therein. As such, KHA Accountants, PLLC cannot be held liable for any information derived from referenced sources. Consult your legal and business advisors prior to making financial decisions. This is intended for illustrative and discussion purposes only.